Traditional 401k Versus a Roth 401k: Choosing a Plan that is Right for You

Since the Roth 401k was first offered in employee benefit plans in 2006, it has joined a Traditional 401k in becoming popular among plans for retirement. The two types of plans have several similarities, but they also have significant differences.

Below is a comparison between a Traditional 401k and a Roth 401k:

Traditional 401k

Roth 401k

Employer Sponsored

Yes

Yes

Income Limitations

Not Subject to Income Limitations

Not Subject to Income Limitations

Contribution Type

Contributions are made on a pre-tax basis

Contributions are made on a post-tax basis

Contribution Limits for 2014

Maximum Contribution of $17,500 with an additional “catch up” provision of $5,500 for taxpayers > 50

Maximum Contribution of $17,500 with an additional “catch up” provision of $5,500 for taxpayers >50

Employer Match Program

May be offered from employers in which contributions are placed in a pre-tax account

May be offered from employers in which contributions are placed in a pre-tax account

Taxed on Withdrawals (after age 59 ½ )

Distributions taxed as current income

Distributions not subject to taxes or penalties if account was held for at least 5 years

IRA Rollforward

Can be rolled into a traditional IRA with no tax payment or into a Roth IRA with a tax payment. IRAs subject to income limitations.

Can be rolled into a Roth IRA with no tax payment. IRAs subject to income limitations.

Minimum Distribution Requirement

Must start withdrawing funds at age 70 ½ unless still working and not a 5% owner of the company

Must start withdrawing funds at age 70 ½ unless still working and not a 5% owner of the company

Early Withdrawal Penalties

Yes-10% penalty plus taxes on early withdrawals including withdrawals for hardships. There are exceptions to early withdrawal penalties.

Yes-Proportion of distribution considered to be earnings will be subject to taxes and penalties. There are exceptions to early withdrawal penalties

Please note that the above chart discusses the general similarities and differences between a Traditional 401k and a Roth 401k. When choosing a retirement plan, keep in mind that every individual’s situation is different and must be taken into consideration.

Below are key tax implications that should be considered when choosing a 401k plan:

Pre-Tax Versus Post Tax Contributions

Traditional 401k

Contributions are made on a before tax basis which leads to a reduction of a taxpayer’s current taxable income

Distributions are later taxed at the prevailing ordinary rate

Contributions are not dollar for dollar meaning that $100 contributed into the plan could result in only $75-$85 in net pay

Roth 401k

Contributions are made on an after tax basis meaning that like wages they are subject to federal, state, social security and Medicare taxes before it is contributed into the account

Distributions are not considered to be income and therefore are not taxed as long as the account was held for at least five years

Contributions are dollar for dollar; meaning that $100 contributed into the plan results in $100 paid out of pocket

Current Versus Future Tax Brackets

Traditional 401k

Beneficial for taxpayers who have higher tax rates in the short term and expect their income to fall into a lower tax bracket in the future

Ability to take a deduction for contributions when tax rates are higher, and are subject to a lower tax for distributions

Ideal for taxpayers who are closer to retirement

Roth 401k

Beneficial for taxpayers who have lower tax rates in the short term and expect their income to fall into a higher tax bracket in the future

Contributions taxed at a lower rate and distributions are not subject to tax when rates are higher

Ideal for taxpayers who are beginning their careers and expect their income to increase

Please note that unlike a Traditional 401k, which can be converted to a Roth 401k, once money is invested into a Roth 401k, it cannot be transferred to a Traditional 401k. A taxpayer can also choose to contribute to both plans simultaneously as long as the combined annual contribution total between both plans does not exceed $17,500 per individual taxpayer under age 50 and $23,000 per individual taxpayer older than age 50.

Should you have any further questions on the comparison between a Traditional 401k and a Roth 401k and/or choosing the right plan to meet your needs, please contact your Marcum Professional.

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